Nouriel Roubini is back at it, delivering the latest battle call in his war against complacent optimism. This time, Dr Doom is concerned about "the mother of all carry trades", where investors are borrowing dollars at negative interest rates (due to low nominal rates, and an ever-depreciating dollar), and investing them in anything that is risky and from emerging markets. Hence the disparity between real economic growth and financial market growth.
This new carry trade is quite dangerous, as it is based on the assumption that the dollar will continue to plunge and emerging market investments will continue to pay off handsomely. Should it unwind, due to a rising dollar or emerging market crisis, markets would become dangerously volatile, which would then hamper the real economy (sound familiar?):
But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally.
So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fueling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades.
The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.
In effect, it has become one big common trade- you short the dollar to buy any (Roubini's emphasis) global risky assets.
Considering the fact that Roubini has built a brand around being a permanent naysayer (one critic dubbed him a "false prophet"), should we be paying attention to his warnings? Or is he simply crying wolf?
Although I tend to be skeptical of Roubini's hysterics, I can't help agreeing with his current prognosis. As I discussed last week, capital flows to emerging markets have taken on a life of their own. Just like in the summer of 2008, where the dollar's decline appeared to be in perpetuity and the BRICs seemed unstoppable, the current market seems to be making a similar one-way bet.
Everything seems to be moving a bit too fast, with investor confidence a bit too high.
(Photo Credit: Wall St. Cheat Sheet)